How To Spot An Undervalued Oil Company

Oil executives have been making headlines recently, due to large purchases of their own company’s stock. In fact, insider buying in the oil industry is higher than any other industry, except the machinery industry.

Who’s buying?

Major insider purchases for the month of March were made by Kinder Morgan (NYSE: KMI) and Diamond Offshore Drilling (NYSE: DO). A major shareholder (Loews Corp.) purchased 685,373 shares in Diamond Offshore on the open market, and Rich Kinder, CEO of Kinder Morgan, purchased 100,000 shares of Kinder Morgan.

The question remains: what does this insider buying mean? To interpret what this means, no one is more qualified, than legendary Fidelity money manager Peter Lynch.

In Chapter 8 of his book, One Up On Wall Street, Peter Lynch explains the 13 characteristics of a perfect stock. One of these characteristics is that insiders of the company are purchasing company stock. Lynch claims that there is no better hint for potential success than when insiders are investing their own money in the company. (One Up On Wall Street, Peter Lynch, P.142)

Lynch proves this theory by explaining that company insiders are generally net sellers of company stock, and not net buyers. And this means that if management is on a buying spree, then the company must be undervalued. He then goes on to explain further that, if insiders are buying more company stock than they are selling, it is very unlikely that the company will go bankrupt within the next six months. (One Up On Wall Street, Peter Lynch, P.143)

The next conclusion he draws, is that when insiders own shares of the company, rewarding shareholders will become management’s first priority. If management is more paycheck oriented, increasing salaries will be deemed more important. But if management owns stock, rewarding shareholders will take precedent, over increasing their own pay. He then concludes that when insiders sell a stock, there are many reasons for this, but when they buy, there is only one reason, and that is that the stock is undervalued. (One Up On Wall Street, Peter Lynch, P.143-44) Related: Oil Prices Won’t Recover Anytime Soon Says Exxon CEO

Does Peter Lynch’s Theory Translate To The Resource Sector?

When explaining what insider buying meant, Peter translated this from a company perspective; ignoring interest rates, and market forecasts. But when a company insider purchases company stock in the energy sector, management can’t afford to ignore oil price forecasts.

From looking at this chart, ignoring the oil price and the market environment can cause a company to go bankrupt, like it did for Red Fork energy in December of 2014. From an investor’s standpoint, Peter’s theory still works. This is because, if an oil insider is buying company stock, it will mean two things; one, that the company is on sound footing and can survive a low priced environment, and two, that the price of oil is near or at a bottom, and the price of oil, as well as the stock, will rise in the near future. Even though Peter ignores interest rates, and market forecasts, oil executives won’t.

His next theory was that companies who purchase their own stock won’t go bankrupt in the next 6 months or less. To test this theory, I looked at the balance sheets of all the companies mentioned above. I used what is called a current ratio to see what type of financial danger they could face in the upcoming year. This is calculated by dividing current assets by current liabilities. Related: Oil Price War May Benefit Both US Shale And Saudi Arabia

The ratios were: for Tall Grass energy 1.37; for Marathon Petroleum 1.32; for Diamond Offshore Drilling 1.05. When calculating this ratio, any number above 1 means a company will not be facing bankruptcy threats in the near future. For Kinder Morgan, I calculated a ratio of .59. Generally, a ratio of .59 means a company could be facing bankruptcy but Kinder Morgan does have a backlog order of $16.4 billion dollars, which could enable it to refinance, or get an extension on short term debt.

(All calculations were done with numbers sourced from Yahoo finance. These numbers were only used for informational purposes, and are not to be used or interpreted as investment advice. Before investing in any companies mentioned make sure to do your own due diligence and consult a qualified financial advisor).

When reviewing Peter’s last theory of management ownership causing management to become more shareholder friendly, I found this to be true for all business sectors. When management owns shares of company stock, they will always act in a shareholder friendly manner. In the resource sector, this is called “Skin in the Game theory.” This means that the more management has to lose, the more likely their policies will be aimed at creating shareholder value.

In conclusion, Peter Lynch’s management ownership theory does remain true when it comes to investing in the energy space. The reason oil executives are buying shares of company stock is because they believe the company is undervalued, and that the price of oil will inevitably rise, because currently, the price of oil is trading at a price that is below the overall cost of production.